3:AM Magazine

Free Markets and the Myth of Earned Inequalities

By Alex Rosenberg.

Conservatives favor the free market as the best solution to economic problems. Conservatives also insist that people have the right to what they have earned. Together the market and the right to keep what one has earned produce persistent and substantial inequalities in income and wealth. These inequalities don’t trouble conservatives. They are the unavoidable and morally permissible outcomes of the combination of the market and our natural rights.

But this conclusion is based on two oversights: one about how free markets work, and the other about whether income inequalities are really earned. Once we detect these oversights, it becomes clear that even if we accept the conservative’s claims about the market and about earned inequalities, we should reject their anti-redistributive conclusions.

Revealing the invisible hand

In 1776 Adam Smith first suggested that free markets make every one better off. From then on economists tried to turn his prose into a mathematical proof. By the 1950s they succeeded: Kenneth Arrow and Gerard Debreu both won Nobel Prizes in economics for proving that the perfectly free market is “allocatively efficient:” it directs every input to its optimal use in producing the largest quantity of the outputs we really want. Add to this proof the catastrophic failure of communist central planning, and it becomes unarguable that free markets are the best way (maybe the only way) to organize an economy.

The economists’ optimality proof requires high-powered mathematics and unrealistic assumptions: individuals are perfectly rational and have complete information, all goods are infinitely divisible (you can buy any amount of a house, car or stick of gum), there are no “externalities” (e.g. manufacturers pay the full cost of their pollution). Most important, the proof that the free market’s hidden hand makes us better off requires that every one is a “price taker:” No one has the power to set prices. The way the proof assures that there are no “price setters” is to assume that there are an infinite number of traders, and constant returns to scale (bigger factories aren’t more productive than smaller ones). These assumptions make “market power” impossible in the model.

The proof that markets are optimal is the backbone of most of economics and it has great policy relevance: it tells us that in a well functioning free market the best thing the government can do is stand back. This is why so many economists (even liberal ones) want minimal governmental interference in the economy. The proof also guides governmental intervention when markets fail. “Market failure” is by definition the failure of an exchange market to achieve optimality owing to the violation of one or more of the proof’s assumptions.

Most market failures share one feature in common: they are cases of people or companies exploiting market power to “set” prices instead of having to “take” them. Monopoly and price fixing among large companies are classic examples of price-setting that makes consumers pay more than is needed to assure optimal supply of one good, leaving not enough left to buy the optimal quantity of some other good. This prevents the market from achieving allocative efficiency. Anti-monopolistic “trust busting” is guided by the economist’s proof that allocative efficiency requires price-taking only.

The trouble with real markets is that left to themselves they always find their way to market failure of one kind or another: monopoly, price-fixing collusion, insider trading, free-riding, even bail-outs. Real markets may start out allocatively efficient, but they never stay that way. That’s why a real commitment to the market requires an equally strong commitment to periodic redistribution.

The market coordinates people’s diverse wants with people’s equally diverse abilities and willingness to meet these wants. The world beats a path to those who are best at meeting its wants and more interested in working hard to so. The inevitable result is ever-increasing wealth among those with the abilities and ambitions the market rewards. But increasing wealth confers market power, and produces market failure. Besides using their resources to undercut and restrict competition, the rich can and do buy favorable judicial decisions, government regulation, and deregulation. They can buy strategically useful “insider” information that enables them to make more or avoid loss. In extreme cases they can corner markets altogether.

So, the market harnesses self-seeking to the general good, but not forever and not by itself. Preserving its benefits requires periodic government redistribution to check the persistent accumulation of price-setting power. The need to eliminate the market-failure-producing disparities in wealth raises an empirical policy problem: to figure out how much redistribution will prevent market failure—progressive income tax, consumption tax, estate tax–without destroying the incentives the market harnesses to make us all better off.

Is taxation slavery?

But the trouble with redistribution, many politicians, some rich people, and a few philosophers argue, is that it’s wrong for the same reason that slavery is wrong, and wrong in a way that swamps whatever good consequences redistribution may have.

Their argument is much simpler and more direct that any economic theory. Outcomes in a free-market economy are earned, deserved. You may not always have an unqualified right to what you inherited or what you won in the lottery. But you have an unqualified moral right to what you have earned. Inequalities, even large ones, between people are morally permissible, perhaps even morally required, when these inequalities are earned. Ayn Rand objectivists, libertarians, and other opponents of government tap into this widespread view when they insist that taxation is slavery.

The trouble for conservatives is that inequalities in wealth and income are almost never earned. That’s because the abilities and ambitions that produced the inequalities were themselves almost never earned. Each of our initial endowment of abilities, disabilities, temperament, character, intelligence, is a matter of genes and prenatal environment over which we had no control and so did not earn. These “God-given” endowments combine with environmental factors through childhood and youth to shape the way we “earn” our livings. But we had no more control over the contributions of family, teachers and others than we did over our genes. Being ambitious or slothful is no more a choice than being left-handed. If the difference between the rich and the poor is the difference between the talented and energetic and the untalented shiftless, then their inequalities are largely unearned.

Of course if we could earn our abilities and our ambitions by freely choosing to work hard enough to earn them, then they would be deserved, and what we gain by using them would itself also be deserved. But we didn’t freely choose our work ethic either. We came into the world having “earned” nothing more or less than a prize in nature’s and culture’s lottery.

Part of the illusion that unequal incomes are earned stems from the fact that when the free market works perfectly, it pays more for abilities and talents that are in higher demand, and does so in amounts exactly equal to their “marginal productivity.” This is the difference that a unit of input of labor makes, holding all other inputs fixed, to the final product. The higher pay accorded by the market to more productive labor is an incentive that harnesses self-interest, not a sign of some moral right to a larger slice of the pie. But it is easy and convenient for the more well paid to make the unwarranted inference from their higher marginal productivity to a moral right to a large share of the proceeds.

If most inequalities are unearned and not deserved, then they don’t have the moral standing that prevents at least some redistribution. Reducing inequalities has benefits for all, when it prevents market failure. The alliance between a commitment to the market and opposition to redistributive taxation is as logically incoherent as it is self-serving.